FUNCTIONAL FORMS IN CONSUMER THEORY

1. C OBB -D OUGLAS UTILITY AND LOG - LINEAR DEMAND SYSTEMS

Consider a utility function given by

n
Y
u = v (x) = xα
i
i
= xα α2 α3
1 x2 x3 · · ·
1
(1)
i=1

We assume that αi > 0. We sometimes assume that Σn

k=1 αk = 1 . If we maximize utility subject to a
budget constraint we obtain

n
Y  
L = xα
i
i
− λ Σn
j=1 pj xj − m (2)
i=1

Differentiating equation 2 we obtain

Qn
∂L αi i=1 xα
i
i

= − λ pi = 0 (3a)
∂xi xi
∂L
= − Σn
j=1 pj xj + m = 0 (3b)
∂λ
If we take the ratio of any of the first n conditions we obtain
Qn α
αi k=1 xk k
xi pi
Qn α =
αj k=1 xk k pj
xj (4)
α i xj pi
⇒ =
α j xi pj
We can now solve the equation for the jth quantity as a function of the ith quantity and the ith and jth
prices. Doing so we obtain

αj xi pi
xj =
αi pj
αj x1 p1 (5)
=
α1 pj
where we treat the first good asymmetrically and solve for each demand as a function of the first. Now
substituting in equation 3b we obtain

Date: October 18, 2005.

1
2 FUNCTIONAL FORMS IN CONSUMER THEORY

∂L
= − Σn
j=1 pj xj + m = 0
∂λ
αj x1 p1
⇒ Σnj=1 pj =m
α1 pj
p1 x1 n (6)
⇒ Σj=1 αj = m
α1
α1 m
⇒ x1 = n
Σj=1 αj p1

Similarly for the other xk so that we have

αk m
xk (p, m) = n (7)
Σj=1 αj pk

This demand equation is clearly homogeneous of degree zero in prices and income. Also note that
demand for the kth good only depends on the kth price. Also note that it is linear in income. This implies
that the expenditure elasticity is equal to 1. This can be seen as follows

αk m
xk = n
Σj=1 αj pk
" # " # (8)
∂ xk m αk 1 m
= αk m = 1
∂m xk Σn
j=1 α j pk Σn
j=1 αj pk

We can obtain the indirect utility function by substituting the optimal xi ’s in the direct utility function.

n
Y
ψ = v (x (p, m) ) = xα
i
i

i=1

n
" # αi
Y m αi
=
i=1
Σn
j=1 αj pi
" # αi   αi (9)
Yn
m αi
=
i=1
Σn
j=1 αj pi
" # Σn
k=1 αk n   αi
m Y αi
=
Σn
j=1 αj pi
i=1

We can also compute the partial derivatives of v(x) with respect to income and price. First with respect
to income
 FUNCTIONAL FORMS IN CONSUMER THEORY 3

" # Σn
k=1 αk n   αi
m Y αi
ψ =
Σn
j=1 αj i=1
pi
" # [ Σnk=1 αk ] n   αi
∂ψ 1 Y αi
( Σn
= ( Σn
k=1 αk ) m
k=1 αk − 1 )
∂m Σn
j=1 αj pi
i=1 (10)
  αi
] Y
n
Σn
  [ − Σn
k=1 αk
αi
=m( k=1 αk − 1 )
( Σn
k=1 αk ) Σn
j=1 αj
i=1
pi
n 
Y  αi
n   [ 1 − Σn
k=1 αk ]
αi
= m ( Σk=1 αk − 1 )
Σn
j=1 αj
pi
i=1
Then we can compute the derivative with respect to the `th price. This yields
" # Σn
k=1 αk
m Y
n
ψ = αi αi pi− αi
Σnj=1 αj i=1
" # (11)
Σn
k=1 αk n 
Y  αi
∂ψ −α` m αi
=
∂p` p` Σn
j=1 αj i=1
pi
If we take the ratio of 11 to 10 we obtain
h i h i h i αi 
Σn
k=1 αk Qn
−α` m αi
∂ψ p` Σn αj i=1 pi
∂p` j=1

∂ψ
=   [ 1 − Σnk=1 αk ] Qn h α i αi
m ( Σk=1 αk − 1 ) Σn
n
j=1 αj
i
∂m i=1 pi
 Σn α   n  − Σk=1 αk
n
− α`
m k=1 k Σj=1 αj (12)
p`
=   [ 1 − Σnk=1 αk ]
m ( Σk=1 αk − 1 ) Σn
n
j=1 αj
−α` 1
= m n
p` Σk=1 αk
which is the negative of 7. This then validates Roy’s identity for Cobb-Douglas preferences.

Now consider the cost minimization problem for Cobb-Douglas preferences. First set up the Lagrangian
problem
n
Y
L = Σn
i=1 pi xi − λ ( xα
i
i
− u) (13)
i=1
The first order conditions are as follows

∂L  αi − 1 αi − 1 αi + 1 
= pi − λ αi xα 1 α2
1 x2 · · · xi− 1 xi xi + 1 · · · = 0, i = 1, . . . , n (14a)
∂xi
αi y
= pi − λ = 0, i = 1, . . . , n (14b)
xi
Yn
∂L
= − xα
i + u = 0
i
(14c)
∂λ i=1
4 FUNCTIONAL FORMS IN CONSUMER THEORY

Taking the ratio of the ith and jth equations we obtain

pi α i xj
= (15)
pj α j xi
We can now solve the equation for the jth quantity as a function of the ith quantity and the ith and jth
prices. Doing so we obtain

αj xi pi
xj =
αi pj
αj x1 p1 (16)
=
α1 pj
where we treat the first good asymmetrically and solve for each demand for a good as a function of the
first. Now substituting in the utility function we obtain

n
Y α
v = xj j
j=1
n  αj (17)
Y αj x1 p1
=
j=1
α1 pj

Because x1 , p1 and α1 do not change with j, they can be factored out of the product to obtain

 Σnj=1 αj Y
n  αj
x1 p1 αj
u = (18)
α1 j=1
pj

We then solve this expression for x1 as a function of u and the other x’s. To do so we divide both sides
by the product term to obtain

 Σnj=1 αj
Σn αj p1 u
x1 j=1 = Q   αj (19)
α1 n αj
j=1 pj

 Σnj=1 αj
α1
We now multiply both sides by p1 to obtain

 Σnj=1 αj
α1
Σn αj p1
u
x1 j=1 = Q   αj (20)
n αj
j=1 pj

1
If we now raise both sides to the power Σn
we find the value of x1
j=1 αj

  Σn 1
  j=1
αj
α1  u
x1 = Qn  αj  (21)
p1 αj
j=1 pj

Similarly for the other xk so that we have

 FUNCTIONAL FORMS IN CONSUMER THEORY 5

  Σn 1
  j=1
αj
αk  u
xk = Qn   αj 
pk αj
j=1 pj
  (22)
  1
n 
Y αj Σn α
j=1 j  
Σn
1
αj  pj  αk
=u j=1

j=1
αj pk
Now if we substitute for the ith x in the cost expression we obtain
  Σn 1 α
  j=1 j
αi  u
C = Σn
i=1 pi Qn   αj 
pi αj
j=1 pj

  Σn 1 α
j=1 j
u (23)
= ( Σn
i=1 α i )  Q  αj 
n αj
j=1 pj

  Σn 1 α
n 
Y αj j=1 j
Σn
1
 pj 
= ( Σn
i=1 α i )u j=1
αj

j=1
αj
Now take the derivative of 23 with respect to pk

  Σn 1 α
n 
Y αj j=1 j
Σn
1
 pj 
C = ( Σn
i=1 α i ) u
j=1
αj

αj
j=1
 
!   1
−1  
n 
Y αj Σn
j=1 αj   n 
Y αj
∂C 1 Σn
1
 pj  αk  pj  (24)
= ( Σn
i=1 α i ) u
j=1
αj

∂ pk Σn
j=1 αj αj pk αj
j=1 j=1
 
  1
n 
Y αj Σn
j=1 αj  
Σn
1
αj
 pj  αk
=u j=1
αj pk
j=1

This is the same as 22 which verifies Shephard’s lemma.

6 FUNCTIONAL FORMS IN CONSUMER THEORY

If we take the Marshallian demand from 7, and substitute in cost from 23 for m, we obtain
αk m
xk = n
Σj=1 αj pk
  Σn 1 α
n 
Y αj j=1 j
1αk Σn
1
 pj 
= n ( Σn
i=1 α i ) u
j=1
αj

Σj=1 αj pk j=1
αj (25)
  Σn 1 α
n 
Y αj j=1 j
αk Σn
1
j=1 αj  pj 
= u
pk αj
j=1
which is also the same as 22. We can also substitute the indirect utility function from 9 into the Hicksian
demands in 23 for u to obtain the Marshallian demands.

  Σn 1 α
n 
Y αj j=1 j
αk Σn
1
j=1 αj  pj 
xk = u
pk αj
j=1

 " #  1   Σn 1 α
Σn
k=1 αk n   αi  Σn
n  αj
αk 
αj
m Y αi
j=1
Y pj
j=1 j

=  
pk  Σnj=1 αj pi  αj
i=1 j=1

" #  (   Σn 1 α
 αi )
1
Σn n  n  αj
Σn 1
k=1 αk
αk   j=1 αj Σn (26)
m Y αi j=1
αj
Y pj
j=1 j

=  
pk  Σn
j=1 αj  pi αj
i=1 j=1

   1
 Yn   αi ! Y n  αj  Σnj=1 αj
αk m αi  pj 
=
pk Σn
j=1 αj  i=1
pi j=1
α j 

αk m
=
pk Σn
j=1 αj
which is the same as 7.

2. CES UTILITY

The CES utility function is given by

γ
u = v (x) = − Σn
k=1 αk xk , αk > 0, γ < 0
γ (27)
u = v (x) = Σn k=1 αk xk , αk > 0, 0 < γ < 1
Demand functions corresponding to the CES utility function are given by
  γ −1 1
pk
αk m
xk (p, m) =   γ −1 1 (28)
pj
Σn
j=1 pj αj
 FUNCTIONAL FORMS IN CONSUMER THEORY 7

Note that we can write this as

gk (p) m
xk (p, m) =
g(p)
where
  γ −1 1
pk
gk (p) = (29)
αk
and

 1
pj γ − 1
g (p) = Σnpj
j=1
αj
As with the Cobb-Douglas utility function, demand is proportional to income or expenditure. The indi-
rect utility function is of the form
m
ψ = v (x (p, m) ) =   γ−1
−1 γ γ
(30)
Σn
j=1 αj γ−1 γ−1
pj
8 FUNCTIONAL FORMS IN CONSUMER THEORY

3. K LEIN -R UBIN (S TONE -G EARY ) UTILITY AND THE LINEAR EXPENDITURE SYSTEM

3.1. Log form of the utility function and Marshallian demand functions. Consider a utility function
given by

u = v (x) = Σn n
k=1 ak log [xk − bk ], ai > 0, (xi − bi ) > 0, Σk=1 ak = 1 (31)
If we maximize utility subject to a budget constraint we obtain

L = Σn n
k=1 ak log [xk − bk ] − λ [ Σj=1 pj xj − m] (32a)
∂L ai
= − λ pi = 0 , i = 1, 2, · · · , n (32b)
∂ xi xi − bi
∂L
= − Σn j=1 pj xj + m = 0 (32c)
∂λ
If we take the ratio any of the first n conditions we obtain
ai
xi − bi pi
aj =
xj − bj
pj
a i (xj − bj ) pi
⇒ =
aj (xi − bi ) pj
aj pi ( xi − bi )
⇒ a i xj − ai bj = (33)
pj
aj pi ( xi − bi )
⇒ xj = + bj
ai pj
aj p1 ( x1 − b1 )
⇒ xj = + bj
a1 pj
where we treat the first good asymmetrically and solve for each demand as a function of the first. Now
substituting in equation 32c we obtain

∂L
= − Σn j=1 pj xj + m =0
∂ λ 
n aj p1 ( x1 − b1 )
⇒ Σj=1 pj + bj =m
a1 pj
 
p1 n aj p1 x1 − aj p1 b1
⇒ Σj=1 + Σn j=1 pj bj =m
a1 a1
p1 n
⇒ Σ aj x1 − aj b1 + Σn j=1 pj bj =m
a1 j=1
p1 n (34)
⇒ Σ aj ( x1 − b1 ) + Σn j=1 pj bj =m
a1 j=1
p1
⇒ ( x1 − b1 ) Σn n
j=1 aj + Σj=1 pj bj =m
a1
p1 p1
⇒ x1 − b1 + Σn j=1 pj bj =m
a1 a1
p1 p1
⇒ x1 =m + b1 − Σnj=1 pj bj
a1 a1
a1 a1 n
⇒ x1 = m + b1 − Σ pj bj
p1 p1 j=1
 FUNCTIONAL FORMS IN CONSUMER THEORY 9

Similarly for the other xk so that we have

ak ak n
xk (p, m) = m + bk − Σ pj bj (35)
pk pk j=1
If we directly exploit the fact Σn
k=1 ak = 1 , we can solve for the demand functions in a slightly simpler
manner. Rearrange the first order conditions to obtain

ai
= λ pi , i = 1, 2, · · · , n
xi − bi (36)
⇒ ai = λ pi (xi − bi)
Now sum over i to obtain

Σn n
i=1 ai = Σi=1 λ pi (xi − bi )

⇒ 1 = λ ( Σn n
i=1 pi xi − Σi=1 pi bi )

1 (37)
⇒ λ =
Σn
i=1 pi x i − Σn
i=1 pi bi

1
⇒ λ =
m − Σn
i=1 pi bi
Equation 32c allows us to substitute m for Σn
i=1 pi xi . If we substitute 37 back into 36 and rearrange we
obtain

ai
= λ pi
xi − bi
ai
⇒ (xi − bi ) =
λ pi
ai (38)
⇒ xi = bi + h i
1
pi m − Σn
j=1 pj bj
ai  
= bi + m − Σn
j=1 pj bj
pi

We often write it in expenditure form as

pk xk = pk bk + ak m − Σn
j=1 pj bj (39)
This demand system is called the linear expenditure system (LES) because expenditure in linear in prices
and income. The demand equations are clearly homogeneous of degree zero in prices and income. Unlike
the Cobb-Douglas function, demand depends on all prices.

The LES has the following interpretation. The consumer spends a ”committed” amount on each
good
(b1, b2 , ... bn ) and then divides the remaining or ”supernumerary” expenditure m − Σn p
j=1 j jx among
the goods in a fixed proportions (a1, a2 , ... an ). The quantities (b1, b2 , ... bn ) are often called a necessary
consumption basket. Notice that the derivative of 35 with respect to expenditure (income) is a constant.
10 FUNCTIONAL FORMS IN CONSUMER THEORY

3.2. Product form of the utility function, the cost function and Hicksian demand functions. The cost
and indirect utility functions for the LES are usually obtained assuming the direct utility function is a
transformation (which doesn’t matter) of the function given in 31, that is

Y
n
ak
u = v (x) = [xk − bk ] , ai > 0, (xi − bi ) > 0, Σn
k=1 ak = 1 (40)
k=1
First set up the Lagrangian problem
n
Y
L = Σn
k=1 pk xk − λ ( (xk − bk )ak − u0) (41)
k=1
The first order conditions are as follows

∂L  
= pi − λ ai (x1 − b1 )a1 (x2 − b2 )a2 . . . (xi−1 − bi−1 )ai−1 (xi − bi )ai −1 (xi+1 − bi+1 )ai+1 . . . = 0, i = 1, . . . , n
∂xi
(42a)
ai v
= pi − λ = 0, i = 1, . . . , n (42b)
xi − bi
∂L Y
n
= − (xk − bk )ak + u = 0 (42c)
∂λ
k=1

Taking the ratio of the ith and jth equations we obtain

pi ai (xj − bj )
= (43)
pj aj (xi − bi )
We can now solve the equation for the jth quantity as a function of the ith quantity and the ith and jth
prices. Doing so we obtain

aj pi(xi − bi)
xj = + bj (44)
ai pj
Now treat the first good asymmetrically and solve for each demand for a good as a function of the first
to obtain

aj p1 (x1 − b1)
xj = + bj (45)
a1pj
Now substituting in the utility function we obtain

Y
n
v = (xj − bk )ak
k=1
(46)
n 
Y a
ak p1 (x1 − b1) k
=
a1pk
k=1
Because x1 , p1 ,a1, and b1 do not change with k, they can be factored out of the product to obtain
 Σnk=1 ak Y
n  a
(x1 − b1)p1 ak k
u = (47)
a1 pk
k=1
 FUNCTIONAL FORMS IN CONSUMER THEORY 11

We then solve this expression for x1 as a function of u and the other x’s. To do so we divide both sides
by the product term to obtain

 Σnk=1 ak
Σn
k=1 ak
p1 u
(x1 − b1) = Q  ak (48)
a1 n ak
k=1 pk

 Σnj=1 aj
a1
We now multiply both sides by p1 to obtain

 Σnk=1 ak
a1
n p1 u
(x1 − b1 )Σk=1 ak = Q  ak (49)
n ak
k=1 pk

1
If we now raise both sides to the power Σn we find the value of x1
j=1 aj

  Σn 1
  k=1
ak
a1  u
x1 − b1 = Qn  ak  (50)
p1 ak
k=1 pk

Similarly for the other xj so that we have

  Σn 1
  k=1
ak
aj  u 
xj − bj = Qn  ak
pj ak
k=1 pk
 
n
Y  ak ! Σn
1
a
k=1 k
 
n
1 pk aj (51)
= u Σk=1 ak
ak pj
k=1
 

Y
n  ak ! Σn
1
a
k=1 k
 
Σn
1
a
pk aj
⇒ xj = u k=1 k + bj
ak pj
k=1

Now note that Σn

k=1 ak = 1 by assumption so that we obtain

  n 
Y ak !
aj pk
xj = u + bj (52)
pj ak
k=1

Now if we substitute for the ith x in the cost expression we obtain

12 FUNCTIONAL FORMS IN CONSUMER THEORY

  n 
Y ak !!
ai pk
C = Σn
i=1 pi u + Σn
i=1 pi bi
pi ak
k=1

Y
n  ak !
pk
=u Σn n
i=1 ai + Σk=1 pk bk
ak
k=1
ak ! (53)
n 
Y pk
=u + Σn
k=1 pk bk
ak
k=1
n
! n
!
Y Y
=u a−a
k
k
pakk + Σn
k=1 pk bk
k=1 k=1
Qn

We usually subsume the constant term k=1 a−a
k
k
somewhere in the function and write the cost func-
tion for the LES as

n
Y
C(u, p) = Σn
k=1 pk bk + u pakk (54)
k=1

The indirect utility function for the LES is given by

m − Σn k=1 pk bk
ψ(m, p) = Qn ak Qn −ak

(55)
( k=1 pk ) k=1 ak
or

m − Σnj=1 pj bj
ψ(m, p) = Qn aj (56)
j=1 pj

4. D EMAND SYSTEMS LINEAR IN EXPENDITURE

Demand systems linear in expenditure are of the form

xi (m, p) = ci (p) + bi (p) m (57)

In a classic paper Gorman (1961) showed any demand system that is consistent with utility maximization
and linear in expenditure must be of the form

gi (p) gi (p)
xi (m, p) = fi (p) − f (p) + m
g (p) g (p)
(58)
gi (p)
= fi (p) + [ m − f (p) ]
g (p)
∂g ∂f
where both f(p) and g(p) are homogeneous of degree one, gi = ∂x i
and fi = ∂x i
. If linearity is required for
all price-expenditure combinations in which p and m are strictly positive, then this results in expenditure
proportionality because the budget constraint implies that
 FUNCTIONAL FORMS IN CONSUMER THEORY 13

 
gk (p)
Σn p
k=1 k k x = Σ n
k=1 k p fk (p) + [ m − f (p) ] =m
g (p)
     
f (p) gk (p) gk (p)
⇒ Σn p
k=1 k fk (p) − + Σ n
k=1 kp m =m
g (p) g (p)
  
f (p) gk (p) m
⇒ Σn k=1 pk fk (p) − + Σn pk gk (p) =m
g (p) g (p) k=1
   (59)
f (p) gk (p) m
⇒ Σn p
k=1 k f k (p) − + g (p) = m, by homogeneity
g (p) g (p)
  
f (p) gk (p)
⇒ Σn k=1 k p fk (p) − + m =m
g (p)
  
f (p) gk (p)
⇒ Σn p
k=1 k f k (p) − =0
g (p)

f gj
and nonnegativity of consumption near zero expenditure implies fj − g
≥ 0 . This then implies that
f gj
fj − g = 0 for all j. Such a demand system comes from an indirect utility function of the form

m − f (p)
ψ (p , m) = (60)
g (p)

To see this take the derivatives of 60 with respect to the kth price and income.

∂ ψ (p , m) g (p) (− fk (p) ) + ( f (p) − m ) gk (p)

=
∂ pk g (p)2
f (p) gk (p) − g (p) fk (p) − m gk (p)
= (61)
g (p)2
∂ ψ (p , m) 1
=
∂m g (p)
Then take the ratio of the derivatives and simplify
∂ ψ (p , m)
∂ pk f (p) gk (p) − g (p) fk (p) − m gk (p)
∂ ψ (p , m)
=
g (p)
∂m
f (p) gk (p) gk (p) (62)
= − fk (p) + − m
g (p) g (p)
= − xk (p , m)
by Roy’s identity. The form of the indirect utility function in 60 is known as the ”Gorman polar form”.
ak
As an example consider f(p) = Σn n n
k=1 pk bk and g(p) = Πk=1 pk with Σk=1 ak = 1 .
ak g(p) gk ak
Then fk = bk , gk = pk and g(p) = pk . This gives as a demand system

gi (p) gi (p)
xi (m, p) = fi (p) − f (p) + m
g (p) g (p)
(63)
ai n ai
= bi − Σ pj bj + m
pi j=1 pi
14 FUNCTIONAL FORMS IN CONSUMER THEORY

which is the linear expenditure system. While the complete class of utility functions leading to demand
systems linear in expenditure is not fully characterized, one important class leading to linear systems is

v (x) = T [ h ( x − b ) ] (64)

where T’(·) > 0 and h is linearly homogeneous. A function v that satisfies equation 64 is said to be
homothetic to the point b. The indifference curves are scaled up versions of a base indifference curve and the
expansion path radiates in a straight line from a translated origin. The Gorman polar form corresponding
to equation 64 has g(·) dual to h(·) with f (p) = Σnk=1 pk bk . In this sense the LES system is a translation of
the Cobb-Douglas system. We can similarly define translations of CES systems.

5. D EMAND SYSTEMS QUADRATIC IN EXPENDITURE

Demand systems quadratic in expenditure are of the form

xi (m, p) = ci (p) + bi (p) m + ai (p) m2 (65)

This specification allows for non-linear relationships between income and consumption as is more com-
monly thought to occur. Van Daal and Merkies commenting on a paper by Hoew, Pollak and Wales show
that theoretically consistent demand system that are quadratic in expenditure must be of the form
    
1 gi γi gi 2f gi γi
xi (m, p) = − m2 + + − m+
γ g γ g γ g γ
     2   (66)
f2 gi γi gi g g gi γi
− − f + fi + χ −
γ g γ g γ γ g γ
We can also write this as
       
1 gi γi gi
2 g g2 gi γi
xi (m , p) = − (m − f ) + ( m − f ) + fi + χ − (67)
γ g γ g γ γ g γ
In 66 and 67 we assume that f, g, and γ are homogeneous of degree 1 and that the function χ(·) is a
2
function of one variable. An alternative is to let α(p) = g(p)
γ(p) and then write 67 as

     
12 gi gi α gi
xi (m , p) = αi − α ( m − f )2 + ( m − f ) + fi + χ αi − α (68)
g g g g g

When γ(·) = 0, these quadratic systems are characterized by the indirect utility functions

g (p) g (p)
ψ (p, m) = − − (69)
m − f (p) γ (p)
or

g (p) α (p)
ψ (p, m) = − − (70)
m − f (p) g (p)
If we write the Gorman polar form in equivalent form as

− g (p)
ψ (p , m) = (71)
m − f (p)
 FUNCTIONAL FORMS IN CONSUMER THEORY 15

it is clear that the quadratic system just adds a term that is homogeneous of degree zero to the Gorman
polar form indirect utility function.

A couple of forms for these functions have been proposed in the literature. They both use the same
ak
functions for f(p) and g(p) as the linear expenditure system, that is, f (p) = Σn n
k=1 pk bk and g (p) = Πk=1 pk
2
λ g (p)
with Σnk=1 ak = 1 . The first specifies α(p) as α (p) = Πn pxk , Σk ck = 1 where parameters λ and ck are
k=1 k
added. The second adds only n parameters and chooses α (p) = Σn
k=1 pk ck . With α(p) = 0, these reduce to
the LES.

6. D EMAND SYSTEMS CHARACTERIZED BY PRICE INDEPENDENT GENERALIZED LINEARITY

(M UELLBAUER )
6.1. Two term polynomial demand systems and PIGL. Consider a demand system with two terms, one
linear and one with a power of m. We can write this as

xi (m, p) = bi (p) m + di (p) mσ (72)

where σ might be 1 or 2 or some higher power. This form does not have a term that is independent of
income. Muellbauer has shown that theoretically plausible demand systems of this form must have the
structure
 
gi γi mσ gi
xi (m, p) = − + m (73)
g γ γ σ−1 g
where both g(p) and γ(p) are linearly homogeneous. The indirect utility function consistent with these
systems is

− m 1 − σ − γ (p) 1 − σ
ψ (p , m) = (74)
g (p) 1 − σ

One problem with such a system is that there no allowance for expenditure that is not dependent on
income. Empirical work tends to find Engel curves that do not pass through the origin and so there is some
desire to add a c(p) term to such systems. The idea is to modify the indirect utility function by subtracting
a function of price from the income term. Specifically, if the indirect utility function is given by

ψ (p , m) = Ω(p , m) (75)
we transform it to be

ψ̂ (p , m) = Ω(p , m − f ( p ) ) (76)

The idea is that we reduce available income for expenditure by some function of prices f(p). If we apply
Roy’s identity to the original and transformed indirect utility functions we obtain
16 FUNCTIONAL FORMS IN CONSUMER THEORY

− ∂ ψ∂(ppkm) − ∂∂pΩk
xk (p , m ) = ∂ ψ (p m)
= ∂Ω
∂m ∂m

h i
∂ ψ̂ (p m) ∂Ω ∂Ω
− − ∂ pk
− ∂m
fi (p)
∂ pk (77)
x̂k (p , m ) = = ∂Ω
∂ ψ̂ (p m)
∂m ∂m

− ∂∂pΩk
= ∂Ω
+ fi (p)
∂m
= xk ( p , m − f (p) ) + fi (p)

What this says is that we can add a constant term (not depending on income) to the demand function by
subtracting some function of price from the measure of income and then adding back the derivative of that
function as the constant. Consider a couple of examples. First consider the simple proportional system

xi (m, p) = bi (p) m (78)

The modified system is given by

x̂i (m, p) = bi (p) ( m − f (p) ) + fi (p) (79)

This is the same as the Gorman polar form in 57 where bi (p) = gi (p)/g(p). Next consider the PIGL system
in 72 where σ = 2. We obtain

− m −1 − γ (p) −1 − m −1 γ (p) −1 g g
ψ (p , m) = −1
= −1
− = − − (80)
g (p) g (p) g (p) −1 m γ
Now transform it by introducing f(p). We obtain

g g
ψ̂ (p , m) = − − (81)
m − f (p) γ
which is the same as the quadratic system in 69. This could also be done for a PIGL system 73 where σ =
3. This would give
 
gi γi m3 gi
xi (m, p) = − 2
+ m
g γ γ g
  (82)
gi γi ( m − f (p) ) 3 gi
x̂i (m, p) = − + ( m − f (p) ) + fi (p)
g γ γ2 g

When expanded this will give a system with linear, quadratic and cubic terms in expenditure and a term
independent of expenditure. But this system is not completely general in that quadratic and cubic terms
will be proportional. The same is true of all polynomial demand systems.
 FUNCTIONAL FORMS IN CONSUMER THEORY 17

6.2. PIGLOG demand systems. Muellbauer also introduced a class of demand systems related to the poly-
nomial PIGL class. The PIGLOG class of demand systems has the form

xi (m, p) = bi (p) m + di (p) m log[ m ] (83)

Expenditure thus enters linearly and as a log function of m. In share form equation 83 can be written

pi xi pi bi (p) m + pi di (p) m log[ m ]

ωi (m, p) = =
m m
pi bi (p) m pi di (p) m log[ m ]
= + (84)
m m
= pi bi (p) + pi di (p) log[ m ]
=b̂i (p) + d̂i(p) log[m]

Thus the share form has a term that is independent of income along with a term that is linear in log m.
Muellbauer has shown that theoretically plausible systems of this form must be written as

gi Gi (p)
xi (m, p) = m − [ log [ m ] − log [ g (p) ] ] m (85)
g G (p)

Here G(p) is homogeneous of degree zero and g(p) is homogeneous of degree 1 and the subscript i as
usual denotes a derivative with respect to the ith price. The indirect utility function associated with 85 is

ψ̂ (p , m) = G (p) [ log [ m ] − log [ g (p) ] ] (86)

Roy’s identity holds as is obvious from

− ∂ ψ ∂(pp,k m)
xk (p , m ) = ∂ ψ (p , m)
∂m

 
G (P ) − gi (p)
+ Gi (p) [ log [ m ] − log [g (p) ] ] (87)
g (p)
= − G (p)
m
 
gi (p) Gi (p)
=m − [ log [ m ] − log [g (p) ] ] m
g (p) G (p)
We will show later that some forms of the translog and the AIDS demand systems are special cases of
the PIGLOG system. The class can be extended by adding terms that are quadratic in log m. More general
systems are discussed in a series of papers by Lewbel in the late 1980’s and early 1990’s.

7. L INEAR TRANSLOG DEMAND SYSTEM

This is usually written in share form as

pi xi (m, p) pi bi   h pk i
ωi(m, p) = = + αi + Σn
j=1 βij log [pj ] 1 − Σn
k=1 bk
m m m (88)
βij = βji , Σn n
i=1 βij = 0 , Σk=1 αk = 0
18 FUNCTIONAL FORMS IN CONSUMER THEORY

The summation condition on the β’s assures homogeneity of degree zero in prices and income because
log[λ pj ] = log[λ] + log[pj ] and the sum in the brackets can be divided into two terms, one equal to
log[λ] Σnj=1 βij .

8. L OG T RANSLOG
This is also written in share form as

αi + Σn n
j=1 βij log [pj ] − log[m] Σj=1 βij
ωi(m, p) = n n
1 + Σj=1 Σk=1 βkj log [pj ] (89)
βij = βji , Σn
k=1 Σn
j=1 βkj = 0, Σn
k=1 αk = 1

9. A LMOST I DEAL D EMAND S YSTEM (AIDS)

ωi(m, p) = αi + Σn k=1 βki log [pk ] + γ [ log [ m ] − log [g (p) ] ] (90a)

1 n
log [ g (p) ] = α0 + Σn
k=1 αk log [pk ] + Σ Σn βk j log [pk ] log [pj ] (90b)
2 k=1 j=1
βij = βji , Σn
k=1 βk = 0, Σn n
k=1 αk = 1 , Σk=1 γk = 0
We assume that g(p) is homogeneous of degree 1 in p which means that g(λp) = λg(p) and log[g(λp)] =
log[λ] + log[g(p)].
 FUNCTIONAL FORMS IN CONSUMER THEORY 19

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